Seafarer Capital Partners, LLC is not registered with the Securities and Exchange Commission or any state, nor does it advise any publicly registered investment companies or other investment vehicles. Seafarer does not currently offer investment advice, nor does it offer, sell, or distribute any security of any kind. Seafarer Capital Partners, LLC does not accept any liability for losses either direct or consequential caused by the use of any of this content. The views and information discussed in this report are as of the date of publication, are subject to change and may not reflect the writer’s current views. The views expressed represent an opinion only and should not be relied upon as investment advice regarding a particular investment or markets in general.

Investment Boom Unsustainable

The Chinese fixed-asset investment boom
of the past decade has been, in a word,
unprecedented. All low-income countries have
required outsized capital stock additions
to make the leap to middle-income status, but
China’s boom is unmatched by anything
on the record books. In fact, by some measures
of physical capital, China looks more like one of
the world’s leading developed economies,
rather than the middle-income economy it is.

As a consequence, we see very little reason
to believe China can continue to rely on
building ever-more skyscrapers, highways, and
manufacturing plants to sustain the kind
of GDP numbers to which Chinese citizens and
global investors have grown accustomed.
In the next 10 years, the onus for growth will
rest squarely on Chinese households and their
willingness and ability to consume. If
consumption fails to grow at a rate well above
historical norms, the economy may be able to
muster only 5% growth at best, a far cry from
the 10% it averaged from 2001 to 2010.

A Decade of Growing Imbalances
The macroeconomic facts of the story provide a
sense of just how dramatic China’s fixed-asset
investment boom has been (Exhibit 1).

In 2000, before the boom kicked off in earnest,
gross capital formation (the GDP accounting
term for investments in physical capital,
otherwise known for its abbreviation, GCF)
accounted for 35% of Chinese economic output.
While large by developed economy standards
(the U.S. 10-year average is 19%, Japan’s
is 23%), it wasn’t terribly atypical for a
high-growth emerging economy. Nor was it
unusual for China: A decade prior, GCF also had
a 35% share. The consistent share of GCF
reflected the balanced growth China enjoyed
in the 1990s. By 2000, the Chinese economy
was 170% larger than it was in 1990, driven by
a 173% increase in investment and an only
slightly lower 156% increase in consumption.

Chinese GDP expanded at a similarly impressive
rate in the 2000s. By 2010, the Chinese
economy was 171% larger than it was in 2000.
But by then, the sources of growth were
anything but balanced. A massive share came
from a surge in fixed-asset investment. China
was spending 273% more on physical capital
than it was in 2000, with GCF accounting for a
staggering 49% share of output by decade’s
end. Yet households were "only" consuming
97% more than they were in 2000, depressing
the share of household consumption of total
GDP to 34% in 2010, a paltry share by any
standard and the lowest level seen in China
since the founding of the People’s Republic.

Unprecedented Intensity
The extreme imbalance between investment
and consumption is striking in and of itself.
After all, the ultimate purpose of any investment
is to consume (eventually). But it appears
even more exceptional in the context of
the three biggest investment-led success
stories of the past 50 years: Japan, Korea, and
Taiwan (Exhibit 2). By any measure of fixed asset
investment intensity--growth rates,
share of cumulative GDP growth, or share of
GDP--China has far surpassed the precedents
set by these three countries in their boom
years. We estimate that, relative to the starting
size of the economy, cumulative additions to
Chinese capital stock in its boom decade have
been 43% greater than Japan’s, 33% greater
than Korea’s, and 49% greater than Taiwan’s.

Just as striking is the relatively feeble
contribution of consumption to Chinese growth
rates. While GCF grew faster than consumption
in the boom decades of Japan, Korea, and
Taiwan, consumption still accounted for at least
half of total economic expansion in each
case, versus the paltry 26% share we see in
China. Somewhat shockingly, while the
investment share of Chinese GDP has exceeded
the consumption share in every year since 2003,
this feat was not achieved in any year by Japan,
Korea, or Taiwan.

China’s Capital Needs
Various "hard" measures of GCF confirm the
outsized role of fixed-asset investment
in the Chinese growth story. As noted, the Chinese economy is roughly 170% larger
than it was a decade ago. But the economy
now consumes 383% more aluminum and
393% more steel. Total expressway mileage is
up 354% over the past decade, the number
of tunnels is up 338%, and floor space under
construction, a concrete measure of real estate
activity, is up 337%.

China bulls, nonetheless, argue that this
rapid build-out of Chinese real estate and
infrastructure makes sense because it correctly
anticipates a rapid increase in consumption.
Even if a good deal of the new floor space goes
unoccupied at the moment, continued
urbanization and rising incomes will eventually
fill that vacuum. And although some of
the new expressways, bridges, and tunnels
may see only a trickle of traffic today, rising
automobile ownership rates will ultimately
generate a steady stream of vehicular
flow. From this perspective, today’s investment
is nothing more than down payment on
tomorrow’s consumption.

But given the immense investments made in
the past decade, consumption has a lot
of catching up to do. And even if the massive
capital additions have correctly anticipated
the consumption growth we’ll see in the
decades to come, the economic rationale for
further outsized capital outlays grows
increasingly weak with each passing year. After
all, any nation, even a rapidly growing one,
needs only so many airports, highways,
high-speed rail lines, and luxury apartments.

Indeed, by some measures, China’s physical
capital base already looks like that of a
major developed economy. Consider, for
example, the installed capacity of China’s steel
industry. Now roughly five times the size
of what it was a decade ago, capacity is nearly
twice that of the United States, Japan,
and the EU-27 countries combined. Notably, the
latter collection of economies has nearly
1 billion people of its own and collective GDP of
about $36.6 trillion, making it more than six
times the size of China’s economy.

China’s expressways, called the National Trunk
Highway System, look overbuilt (Exhibit 3).
By year-end 2011, the highway system will have
quintupled its 2000 length. Heading into the
year, the total length of China’s highways
(45,554 miles) was already on par with that of
the U.S. Interstate Highway System (46,876
miles), a country of similar geographic size, but
with three times as many cars on the road.
While growing Chinese vehicle ownership
rates are likely to trim some of the bloat in the
next couple of decades, the rationale for building more expressways at a rate comparable
to what we’ve seen in the past 10 years is
very limited.

The biggest contributor to China’s fixed-asset
investment boom, particularly in the past few
years, has been residential real estate.
Throughout the 2000s, China built housing at a
truly blistering pace, adding a cumulative
120 square feet in residential floor space per
person from 2001 to 2010 (Exhibit 4). This
year alone, China will add nearly 18 square feet
in residential floor space per person.

In some respects, this housing boom is
understandable, given the significant additions
China made to its urban population over
the period. What is less understandable is the
roughly 80% surge in the rate of floor
space additions we’ve seen in the past few
years, which has not been accompanied
by a comparable surge in urbanization.
At present, on a per-capita basis, China now
has nearly five times the amount of residential
floor space under construction as peak-housingboom
United States. This is particularly
remarkable because, despite enormous gains in
wealth and income, the Chinese remain
on average much poorer than their American
counterparts, and they tend to occupy
residences that are much smaller.

33 New Yorks
Perhaps the biggest counterargument to the
overbuilding thesis goes as follows:
Despite the massive urbanization of the past
couple of decades, China remains rural by
global standards and will continue to require
large additions to its capital stock as it
accommodates new urbanites. According to
Chinese government figures, even after an
influx of 207 million new urban residents in the
past decade, only 50% of the population
resides in urban areas (Exhibit 5). An increase
to 70% urban, a level typical of the high
middle-income status to which China aspires,
would add another 272 million to China’s urban
total. That’s equivalent to adding 33 cities the
size of New York.

While the notion of "33 New Yorks" is intuitively powerful, we’d strongly caution
investors against taking the data underpinning
the "stronger for longer" urbanization
story at face value. That’s because countries
use very different definitions of what
constitutes urban. As a result, relying on
headline data alone can lead to ill-informed
conclusions. Consider the fact that China’s
self-reported urban share of 50% is equivalent
to reported figures from Ghana (50.7%)
and apparently well below that of North Korea
(60.1%), which remains largely a subsistence
agriculture economy.

As it turns out, China’s definition of urban is
stricter than most, effectively portraying
the country as more rural than it might
otherwise appear and potentially overstating
the remaining runway for further urbanization.
China’s statistics bureau generally requires
a density of 1,500 people per square kilometer
for a population cohort to be deemed urban. By
this hurdle rate, four of the top 10 largest
U.S. cities would fail to meet China’s definition
of urban, not to mention hundreds of suburbs.
While the granular data necessary to
reformulate China’s urban/rural breakdown on
a more apples-to-apples basis with that
of the United States isn’t made available, it
seems fair to assume that such an undertaking
might add at least 10 percentage points to
China’s urbanization level, significantly
curtailing the urbanization upside promoted by
China bulls.

Paths to RebalancingAll told, we expect to see significantly lower
GCF growth in the coming decade than
China had in the decade just past. As a result,
for China to sustain robust economic growth
over the next 10 years, household consumption
will need to grow at above-trend rates. In
effect, China will need to rebalance its
economy toward a more normal composition
of consumption and investment. Chinese
policymakers are not blind to the need
to increase consumption. Government officials
recently said that their objective is to increase consumption’s share of GDP to 50%
by the end of the decade.

There are two ways to achieve this rebalancing,
of course: 1) stronger growth in consumer
spending or 2) weaker growth in fixed-asset
investment. Unfortunately, the track record
established by previous booms suggests
that the latter outcome is more likely than the
former. Consider the average GCF growth
turned in by Japan, Korea, and Taiwan in the
decade after each country’s investment
boom: 1.2%, 2.4%, and 5.9%, respectively
(Exhibit 6). If China were to achieve the
average of those three (about 3%) in its own
postboom decade and household consumption
continued to expand at the rate it has in the
past decade (7%), total GDP would grow
at 4.8%, well below the 10.5% it averaged in
the 2000s. Even if consumption were to
expand at 12% annually, a level it achieved not
once in the past decade, GDP would grow
at 7.5%--stellar by developed-markets
standards, but below what Chinese citizens
and global investors have come to expect.

Notably, in the case of Japan, Korea, and
Taiwan, GCF growth postboom was inversely
related to the size of the boom. Japan
and Korea had larger booms (GCF averaged a
37% share of GDP in the boom decade), leading
to weaker GCF growth postboom. Taiwan had a
relatively smaller boom (31% share of GDP)
and saw fairly robust GCF growth postboom.
With this in mind, it seems reasonable to
believe that, because China’s investment boom
has been both longer and stronger than its
antecedents, its postboom decade will require
more-modest additions to the capital stock
than the cases of Japan, Korea, or Taiwan. This
suggests even 3% GCF growth would be a fairly
rosy outcome by historical standards. Assuming
instead 1% GCF growth and 7% consumption
growth would put GDP growth at 3.8%--a
potentially troubling outcome not only for China
but also for the global economy as a whole.